Uruguay—Letter of Intent, Memorandum of Economic Policies, and Technical Memorandum of Understanding

Montevideo, June 18, 2002

Mr. Horst Köhler
Managing Director
International Monetary Fund

Dear Mr. Köhler:

The economic disruption in the region has proven to be more severe and protracted than anticipated at the start of our adjustment program. Contagion from Argentina has prompted large outflows of nonresident foreign currency deposits and losses in international reserves, while economic activity has weakened, adversely affecting the public finances.

Against this background, the government has strengthened its economic program, as laid out in the attached Memorandum of Economic Policies. The three pillars of the enhanced strategy are: (i) fiscal reforms to underscore the government's commitment to sustainable public finances and debt over the medium term; (ii) measures to raise confidence in the soundness of the banking system; and (iii) structural reforms to promote investment and future growth.

In support of these enhanced efforts, the Government of Uruguay requests an augmentation of its Stand-By Arrangement in an amount equal to SDR 1158.2 million (378 percent of quota).

We are confident that the initiatives set out here will be sufficient to stabilize the situation quickly, while setting the basis for a durable resumption of economic growth. Nonetheless, the government stands ready, in consultation with the Fund, to take whatever additional measures necessary to ensure the success of the program.

Sincerely

Memorandum of Economic and Financial Policies

I. Background and Macroeconomic Framework

1. The Argentine crisis has had more severe and lasting effects in the Uruguayan economy than previously anticipated. The contagion has prompted large outflows of foreign currency deposits, additional losses of international reserves, and delays in the recovery of domestic demand and production, with adverse consequences for the public finances. To restore confidence, the government is requesting additional assistance from international financial organizations for the purpose of strengthening the banking system and building up international reserves, and is taking steps to reinforce its economic program and ensure sustainability of the public finances over the medium term.

2. Given the weak outturn for domestic demand so far in the year, and despite an emerging recovery in exports, we are now projecting real GDP to fall by 7 percent in 2002 and to recover by 2 percent in 2003. Inflation is projected to reach around 11 percent during 2002 and to decline slightly during 2003. Reflecting the weakness of domestic demand and some recovery in exports, the external current account deficit will shift into balance in 2002 and to a small surplus in 2003 from a deficit of 2.5 percent of GDP in 2001.

II. Strengthening the Banking System

3. The government has designed a strategy to reinforce confidence in the banking system. A centerpiece of this strategy is the establishment of a fund (Fondo de Fortalecimiento del Sistema Bancario, FFSB) to provide liquidity assistance, with appropriate conditionality, to public and private banks that meet the necessary solvency conditions. The fund is also designed to address recapitalization needs under appropriate conditions to encourage any needed restructuring. (A description of the FFSB is presented in Box 1.) Pending congressional approval of a law (September), the government has issued a decree that will allow the operation of the main elements of the FFSB in the interim period. In particular, the decree established a steering committee empowered to grant liquidity support through the central bank and, if needed, capitalize banks through the Corporación Nacional de Desarrollo (CND) under the supervision of the central bank following the same terms and conditions envisaged under the FFSB. At the same time, the government is bringing forward the restructuring of public banks relative to what had been envisaged in the original program and is strengthening bank supervision.

Box 1. Fondo de Fortalecimiemto del Sistema Bancario - FFSB I. Objective Strengthen confidence in the soundness of the Uruguayan financial system through financial support and restructuring. II. Legal Framework and Organization The FFSB will be a government institution vested with appropriate powers and resources to provide financial support to banks. The FFSB will be governed by a chief executive officer and a steering committee that includes representatives from BCU and the Ministry of Economy and Finance. Resources of the FFSB are expected to be US$2.5 billion subscribed in the form of dollar denominated government securities. Up to US$1 billion of these securities could be rediscounted at BCU for liquidity needs. Beginning with the issuance of the decree, the FFSB and related activities will be subject to annual audits of international standards. III. Eligibility The FFSB will provide last resort liquidity support to banks. Moreover, if needed, it may also provide resources to recapitalize banks. All such support will be subject to strict conditionality as described below. IV. Modalities Liquidity support will be provided only to solvent banks against regularization plans, comprising cash flow management programs and compliance with prudential regulations. Conditionality will include guarantees from international reputable banks or provision of appropriate collateral and pledge of banks shares. Support will be at penal rates. Conditionality for recapitalization will preclude any subsidy or bail out for original shareholders, whose equity stake will cover existing losses. Recapitalization of banks may involve mergers, purchase, and other restructuring mechanisms. An appropriate business plan must include a strategy to sell the government's stake back to the private sector within a maximum of two years.

4. Upon establishment of the FFSB, the present liquidity facilities of the central bank will be revamped to provide only nonrecurrent short-term assistance to meet settlement obligations.

5. The restructuring of public banks envisaged in the original program will be brought forward. This effort aims at strengthening their finances and management and redefining some of their roles. A law has been presented to congress making public banks subject to the same prudential regulations and associated sanctions applicable to all banks (prior action).

• The on-going restructuring of the Mortgage Bank (BHU) will be speeded up. The government has recapitalized the bank, its involvement in new construction operations has been halted, its management is being strengthened, and efforts are being made to strengthen collection of outstanding loans. Nonetheless, the government recognizes the need for additional restructuring and will bring forward to July the presentation to congress of a comprehensive proposal (structural performance criterion). This restructuring proposal has been designed with assistance from the World Bank, which is supporting the initiative as part of a structural adjustment loan.
  
  
• The Banco de la República (BROU) is also being restructured. Specifically, internal controls are being strengthened, the classification of its loan portfolio is being conducted in accordance with central bank directives and nonperforming loans appropriately provisioned, and work is underway to improve the information system to strengthen BROU's financial decision-making process, supervision by the central bank, and disclosure to the public. This process will be speeded up, with a view to completion by end-2002.

6. In the case of international banks, they have managed to finance their deposit outflows using their ample liquid reserves and support from parent institutions. The government has been assured that this support will continue in the future.

7. Strict compliance with prudential requirements will also be important to reinforce confidence in the banking system. To ensure this, the central bank is strengthening further its banking supervision capacity with assistance from the Fund. In particular, the Superintendency of Banks will: (i) increase its staffing for on-site examinations and improve training by August 2002, (ii) improve methodologies and techniques to assess current prudential regulations and develop a framework for compliance with international standards and best practices, (iii) evaluate the adequacy of the CAMELS methodology and develop a plan to strengthen it by September 2002, and (iv) improve the quality and frequency of financial information published by December 2002. While current legislation on corporate restructuring and bankruptcy is adequate, the government will keep under review the need for any legal and institutional changes in these areas.

III. Fiscal Sustainability

8. The government is determined to ensure the sustainability of the public debt over the medium term and is taking steps to strengthen the public finances in spite of the more difficult conditions being faced by Uruguay. As envisaged in the original program, the government is seeking a permanent increase in the primary surplus, raising it from 1 percent of GDP in 2001 to around 4 percent by 2004 and beyond. This target should be adequate to begin to reduce the public debt to GDP ratio from 2004 onwards, even in the eventuality of higher interest rates, a more depreciated peso, and additional debt to assist the banking system.

9. With respect to 2002, the government took a number of significant measures early in the year to strengthen the public finances, including limiting the increases in wages and introducing a package of tax and expenditure measures which was described in our letter of March 12, 2002. However, because of the weaker economy, potential deviations have emerged with respect to the program fiscal objectives (deficits of 2.5 percent of GDP in 2002 and 1.5 percent in 2003). To get the program back on track, the government has put in place an ambitious fiscal package that combines revenue measures with expenditure cuts and would yield the equivalent of about 3.3 percent of GDP on an annual basis.

• Measures on the revenue side have already been put in place with a yield of about 2.1 percent of GDP on an annual basis, including a tax package recently approved by congress. This package comprised an increase in the tax on pensions and wages, increases in excises, and a broadening of the VAT.
  
  
• Measures on the expenditure side have also been introduced yielding savings of about 1.2 percent of GDP on an annual basis, including savings in across-the-board operational expenditures, overtime, fixed-term employment, and the rationalization of government spending in areas such as public health care in general and the public enterprises in particular.

10. The full-year effect of the measures introduced in 2002 and a modest recovery in domestic demand next year are projected to result in a further strengthening of the public finances in 2003. However, a gap of about 0.3 percent of GDP with respect to the program objectives will still need to be filled, reflecting the additional interest costs arising from the funding of the FFSB. The situation will be re-assessed during the September review, at which time the government will identify any additional measures needed to close this gap.

11. Over the medium term, additional efforts will be needed to achieve the significant increase in the primary surplus that is required to ensure public debt sustainability. In particular, this is needed because some of the tax increases approved by congress, with an annual tax yield of 1.2 percent of GDP, are scheduled to expire at the end of 2003.

• To address this problem, the government will seek congressional approval of a law giving it powers to extend the measures that are scheduled to expire at the end of 2003 (performance criterion). These powers would be exercised if there were delays in the approval of broader revenue enhancing tax reform.



• The government recognizes that the current tax structure is in need of simplification and rationalization. In this context, the government will bring forward the introduction of the comprehensive tax reform envisaged in the original program. This reform will consolidate the tax system to four taxes: VAT, excises, income, and trade tariffs. It will be prepared in the coming weeks with assistance from the Fund and will be submitted to congress by December 2002, with approval scheduled for mid-2003, and will become effective at the end of 2003. These efforts will be accompanied by steps to strengthen tax administration.



• As part of its efforts to strengthen medium-term sustainability of the public finances, the government will introduce a more comprehensive reform of public employment than envisaged in the original program. A proposal already has been submitted to congress in June to establish more flexible labor rules for new employees in the civil service. In addition, the government has begun to take steps to reduce overstaffing, especially in the public enterprises and will shortly revise bonus policies in these enterprises to eliminate distortions in remunerations linked to productivity clauses. Further expenditure measures to strengthen the primary position in the medium term will be discussed in the November review.

IV. Exchange Rate and Monetary Policies

12. Over the past year the exchange rate has been managed on an increasingly flexible basis. This policy has worked well and the government has decided to complete the transition to a fully flexible exchange rate regime, by floating the peso effective June 20, 2002. The government is committed to a high degree of exchange rate flexibility, with only limited intervention aimed at ensuring orderly market conditions. The central bank is working to help the private sector to better manage its exchange rate risk. In particular, Fund technical assistance has been requested to create an institutional framework to foster the establishment of an efficient forward exchange rate market.

13. In the context of a more flexible exchange rate regime, monetary policy will play a key role in keeping inflation in check. The peso monetary base has been adopted as nominal anchor. To implement this policy, the program--adjusting for the provision of dollar liquidity to banks--includes a floor on the net international reserves of the central bank and a ceiling on its net domestic assets. Toward this end: (i) auctions of peso Treasury bills held by the central bank began in May; (ii) secondary market operations (including repo and reverse repo operations) will begin by the end of June; (iii) a Lombard rate for banks will be established by the end of June; (iv) to foster demand for peso-denominated securities, the government introduced, effective June 1, the CPI indexed unit envisaged in the original program to foster the demand for peso denominated securities; and (v) a system for forecasting daily peso liquidity conditions is being put in place.

V. Balance of Payments and Financing

14. For 2002, the narrowing of the external current account deficit will be more than offset by a deterioration in net capital inflows that goes beyond that envisaged in the original program. Accordingly, to maintain an adequate level of gross international reserves, the government has requested additional assistance from international financial institutions. Over the next 18 months, the government is seeking extra World Bank and Inter American Development Bank assistance for about US$1.1 billion, which would supplement the US$1.5 billion requested from the Fund. Of the SDR 1158.2 million augmentation requested, the government proposes that SDR 386.1 million be under the supplemental reserve facility. We anticipate that such financing assurance will strengthen confidence in the banking system, and contribute to reduce the potential deficit in the financial account. If assistance from the IFI's is fully drawn, gross reserves will reach US$1.5 billion by end 2002 and US$1.8 billion at end 2003. If capital account prospects were to improve markedly, the government will consider treating the Stand-By Arrangement as precautionary.

VI. Transparency

15. As part of its efforts to reinforce confidence, the government is taking additional steps to improve economic transparency. In this context, the central bank will begin daily publication of gross and net international reserves in the last week of June; a broader move to the publication of comprehensive data in accordance with the Fund's Special Data Dissemination Standards is expected by end-August. The government will also start weekly publication of other banking information by August (performance criterion). Government representatives intend to meet with domestic and foreign investors at an early stage to explain the strategy described in this letter, and an investor relations office will be established by August to help strengthen the flow of information to investors.

VII. Policies for Fostering Growth

16. Creating the basis for a resumption of economic growth will also be critical to restoring confidence and ensuring debt sustainability over the medium term. As described in the letter of March 12, 2002, an important role in this regard is to be played by the government's decision to open to private initiative activities previously reserved for the public sector. In this regard, the government is bringing forward the introduction of new regulatory frameworks in several areas including for electricity, telecommunications, water and sewage, railroad, transportation, etc. (these measures are described in Box 2). At the same time, the government is speeding up the granting of concessions to the private sector. These include: (i) concession of airwave frequencies to be awarded no later than December 2002; (ii) transferring to the private sector the concession for the construction and operation of roads in the country; and (iii) concession of freight activities in the Montevideo airport to be awarded in September 2002.

Box 2. Changes in Regulatory Framework I. Objectives To facilitate private sector investment in areas previously reserved for the public sector, foster competition, and establish a cooperative environment between private and public operators. II. Actions and timing 1. Electricity a. Introduction of a new regulatory framework for the transmission and distribution of electricity. Decree to be issued in June 2002. b. Introduction of new guidelines for the pricing of services provided by the state electricity company (UTE) to private providers. Decree to be issued October 2002. c. Introduction of new guidelines for the interaction of public and private sector operators. Decree to be issued December 2002. d. Introduction of new legislation to foster competition in the sector. Law proposal to be presented in March 2003. 2. Telecommunications a. Introduction of new regulatory framework for the sector. Proposal to be submitted to congress in September 2002. b. Introduction of new legislation to foster competition in the sector. Law proposal to be presented in December 2002. 3. Oil activities a. Invite bids for partnership arrangement with the state company (ANCAP) by December 2002. b. Submission to congress of a law to permit competition in the oil sector by December 2002. 4. Water and sewage a. Introduction of new regulatory framework for the sector. Proposal to be submitted to congress in September 2002. b. Introduction of new quality standards and controls to facilitate private sector investment. Decree to be issued in December 2002. c. Invite bids to improve services in Montevideo by December 2002. d. Invite bids for private sector participation in sewage treatment plants by March 2003. 5. Natural gas a. Introduction of new guidelines to strengthen competition in the sector. Proposal to be submitted to congress in June 2003. 6. Railroad a. Introduction of new regulatory framework to foster competition as well as facilitate cooperation between public and the new private operators and of new guidelines for the pricing of services provided by the state company (AFE) to private operators. Decree to be issued in December 2002. b. Invite bids for private sector participation in this sector by December 2002. 7. Postal services a. Introduction of new regulatory framework for the sector. Proposal to be submitted to congress by September 2002. b. Introduction of new operating rules to allow for enhanced competition in the sector. Decree to be issued in December 2002.

VIII. Program Monitoring

17. The revised program will be monitored on the basis of monthly reviews in July, August, and September, before moving to quarterly reviews, the first of which will be in November 2002. Quantitative and structural performance criteria, as well as prior actions, indicative targets, and benchmarks, are set out in Tables 1 and 2. In light of the changes in economic circumstances, the government is requesting a modification of the end-June, and end-September targets under the original program; moreover, it is requested that the end-December performance criteria be replaced by indicative targets until they are reset by the time of the third review.

Table 2. Uruguay: Prior Actions, Indicative Targets, and Structural Benchmarks under the 2002 Economic Program
A. Prior Actions
1. Decree establishing the Steering Committee for Bank Restructuring, including through the designation of a commission to oversee and operationalize the FFSB by providing adequate financial resources and personel
2. Take action to place on Congressional agenda discussion proposal making public banks subject prudential regulations and associated sanctions applicable to all banks
3. Announcement of daily publication of international reserve data beginning June 26
B. Structural benchmarks
1. Development of peso-denominated and inflation-indexed securities.	30-Jun
2. Decree issued on the introduction of voluntary retirement and redundancy programs in the public enterprises	30-Jun
3. Weekly publication of banking data with a one-week lag.	31-Aug
4. Evaluation of the adequacy of BROU's current regularization plan and development of a plan of compliance with all prudential regulations.	31-Aug
5. Presentation to Congress of the reform of the pension system for bank employees and the military.	31-Oct
6. Presentation to Congress of a comprehensive reform to rationalize and simplify the tax system.	31-Dec
7. Presentation to Congress legislation to foster competition in the telecommunications sector	31-Dec
8. Presentation to Congress of legislation to foster competetion in the oil sector	31-Dec
Sources: Ministry of Economy and Finance; and Central Bank of Uruguay.

Technical Memorandum of Understanding

This memorandum presents the definitions of the variables included in the quantitative performance criteria annexed to the Policy Memorandum.

1. Cumulative balance of the Combined Public Sector. The Combined Public Sector comprises the Central Administration (including as defined in "Article 220" of the Constitution, Salto Grande, and the funds managed directly in the ministries (Fondos de Libre Disponibilidad), the social security system (Banco de Previsión Social), the local governments (Intendencias), the public enterprises (ANCAP, ANTEL, UTE, OSE, AFE, ANP, INC, CND and ANCO), and the quasi-fiscal balance of the Central Bank (BCU). The public sector balance, excluding valuation adjustments, will be measured from below the line on the basis of information provided by the BCU on: (a) the change in the nonfinancial public sector debt (defined below), including all short-term debt, in foreign currency and pesos; (b) change in net bank credit to the nonfinancial public sector in foreign currency and pesos; (c) other non-bank financing including privatization; and (d) the quasi-fiscal balance of the BCU (as defined below). The limit on the balance of the combined public sector will be adjusted downward (upward), i.e., the deficit would be allowed to widen (narrow), by the amount that the actual social security contributions to the private pension system exceeds (falls short) the projected amount in the program.

2. The quasi-fiscal balance of the BCU is defined as interest earnings on gross international reserves, as defined below, and other earnings including those on other foreign and domestic assets minus operating expenses, commissions paid, and interest paid on domestic and foreign debt administered by the BCU.

3. Cumulative ceiling on general government expenditure applies to total (current and capital) noninterest expenditure of the central administration (includes Fondos de Libre Disponibilidad but excludes transfers to the social security system and automatic transfers to the private pension funds (AFAP), and on internal transfers) and social security system (BPS).

4. Cumulative changes in net domestic assets (NDA) of the BCU is defined as the difference between currency held outside banks and net international reserves (NIR) of the BCU as defined in 6 below net of program liquidity support. The flow of NIR will be valued at the average exchange rate projected in the program for the corresponding quarter.

5. The NDA ceiling will be adjusted upward for documented liquidity support which is to be provided in the first instance by the BCU, as authorized by the Steering Committee created by the Decree, and subsequently by the FFSB. Such liquidity is to be provided only when Bank owners provide a stand-by guarantee issued by an international well rated bank equivalent to the financial resources requested or in the absence of the above, when the bank provides collateral consisting of high quality loan assets (Category A loans) in a proportion not lower than 2 to 1 and, in addition, pledge the bank's share in proportion of 1 to 1. The BCU, and subsequently the FFSB, will provide daily reports to the IMF on the magnitude of liquidity support.

6. Cumulative changes in net international reserves (NIR) of the BCU. NIR is defined as the difference between the gross international reserves and BCU reserve liabilities. Gross international reserves include all foreign exchange assets that are in the direct effective control of the BCU and are readily available for such purposes of the BCU as intervention or the direct financing of payment imbalances. Such assets may be in any of the following forms, provided that they meet the test of effective control and ready availability for use: currency, bank deposits in nonresident institutions and government securities and other bonds and notes issued by non-residents (with a rating not below "A" in the classification of Fitch IBCA and Standard and Poor's or "A2" in the classification of Moody's). In addition, holdings of SDRs or of monetary gold would be included under gross reserves assets (provided they meet the test of effective control and ready availability of use) as would the reserve position in the IMF.

• Excluded from gross international reserves are all foreign currency claims arising from off-balance sheet transactions (such as derivatives instruments), claims on residents, capital subscriptions in international financial institutions, any assets in nonconvertible currencies, claims on any nonresident Uruguay-owned institutions, or any amounts (in all components of assets, including gold) that have been pledged in a direct or contingent way.
  
  
• BCU reserve liabilities include all foreign currency-denominated liabilities of the BCU with original maturity of one year or less to residents and nonresidents, the use of Fund resources, any net position on foreign exchange derivatives with both residents and nonresidents undertaken directly by the BCU or by other financial institutions on behalf of the BCU.
  
  
• For the purpose of the NIR calculation, (a) the gold holdings of the BCU will be valued at the accounting rate of US$42 per troy ounce; (b) liabilities to the IMF will be valued at US$/SDR rate of December 31, 2001; (c) gains or losses from gold-swaps and other operations will be excluded; and (d) non-U.S. dollar denominated foreign assets and liabilities will be converted into U.S. dollars at the market exchange rates of the respective currencies as of December 31, 2001.

7. The NIR floor will be adjusted upward (downward) by the difference between actual and scheduled disbursement by the World Bank and IDB as reflected in Schedule A below.

8. The nonfinancial public sector gross debt refers to (a) the outstanding stock of gross debt in domestic and foreign currency owed or guaranteed by the public sector as defined in (1) above excluding the BCU.¹ Debt in the form of leases will be calculated as the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.²

9. The overall nonfinancial public sector debt ceiling will be adjusted upward (downward) by (1) the upward (downward) revisions made to the actual non-financial public sector gross debt stock at end-2001; (2) the difference between the actual and projected amount of social security contributions that are transferred to private pension funds; (3) the difference between actual and scheduled disbursement by the World Bank and IDB as reflected in Schedule A below; and (4) the overperformance with respect to the targets on the BCU's net international reserves up to a limit of US$250 million. The overall ceiling will be adjusted upward by the magnitude of public debt issued for recapitalization of banks in accordance with understanding under the program and elaborated in the Supplement to the Staff Report, under 2.c.3 and 2.c.4. Schedule A: Planned Disbursement by the WB and IDB

	June	July	August	Sept.	Oct.	Nov.	Dec.
Disbursement of IFI's	34.0	0.0	0.0	334.0	0.0	50.0	34.7

Schedule B: Planned debt servicing by the nonfinancial public sector

	June	July	August	Sept.	Oct.	Nov.	Dec.
Amortization	75.2	84.4	69.6	124.2	54.2	68.9	175.9